Reverse Insolvency: A Judicial Innovation with Unintended Consequences

Introduction

Due to the claims of homebuyers, the Insolvency and Bankruptcy Code, 2016¹ (hereinafter, “the Code or IBC”) has seen several developments since its inception. A recent judicial experiment in this respect is the National Company Law Appellate Tribunal (NCLAT) devised “reverse corporate insolvency resolution process (reverse CIRP)”, which has no genesis under the Code. This concept was formulated to protect the interests of the allottees of real estate projects whose interests (getting possession of the unit) conflicted with the interests of other financial creditors concerned with the repayment of their money. Furthermore, even though real estate allottees are now financial creditors, the Tribunal thought they did not have the commercial expertise to understand the viability of a resolution plan. Considering this unique position of homebuyers, the NCLAT brought in this innovation.

However, judicial innovations may only sometimes lead to desirable outcomes. The danger looms over the phenomenon of reverse CIRP, given the porousness concerning the funds of the project. In terms of Section 4(2)(l)(D) of the Real Estate (Regulation and Development) Act, 2016² (hereinafter, “RERA”), 70% of the amount realised for the real estate project has to be kept in a separate account only for meeting project costs. However, India has witnessed several flagrant violations of this requirement. The ongoing “Supertech’” controversy was triggered when “Supertech Limited” did not maintain 70% of the funds in this account. Additionally, Maharashtra has witnessed many instances of funds divergence from such accounts.

The tribunals have yet to implement this condition in most reverse CIRP cases consistently. The likely outcome would be the enhancement of the risks of some stakeholders (promoters) benefiting at the expense of others. The thrust here is that an objective legal criterion for checking the funds is critical for an effective reverse CIRP process. Therefore, a shift from the ex-post determination in reverse CIRP cases to formulating an ex-ante regime can help overcome the promoter’s self-serving tendencies and bring a sense of predictability to the process.

This blog will provide an overview of the reverse CIRP process and reveal its shortcomings. It will also consider the implications of this shortcoming from the MeldModel, which is a synthesis of exclusive legal positivism (ELP). In furtherance of this model, this blog will adopt an ELP lens to reverse CIRP and analyse the consequence of departing from it through law and economics to make a case for an ex-ante regime.

An overview of reverse CIRP

In light of the specific concerns of homebuyers, the NCLAT formulated the doctrine of reverse CIRP while deciding an appeal in Flat Buyers Assn. v. Umang Realtech (P) Ltd.³ The idea provides that in the case of real estate companies, the promoter will disburse funds as a lender and not as a promoter to ensure the completion of the project. The NCLAT has also, in later judgments, ruled that the reverse CIRP should be carried out projectwise.

On 15-2-2024, the Insolvency and Bankruptcy Board of India (IBBI) notified the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) (Amendment) Regulations, 2024⁴ (Amendment). The Amendment intends to streamline and bridge the gaps faced in the corporate insolvency resolution process (CIRP) of real estate companies under the Insolvency and Bankruptcy Code, 2016 (IBC). The Amendment follows the judgment of the Supreme Court of India, which upheld an innovative projectwise approach adopted by the NCLAT to streamline resolution.

Prior to the Amendment, all ongoing projects would be brought under the sweep of the CIRP upon commencement of the CIRP of a real estate company, at the helm of which would be the resolution professional (RP). This was expected to culminate in a resolution plan for the corporate debtor as a whole. Invariably, this process would (i) accentuate cash flow issues; (ii) deter potential resolution applicants; and (iii) further agonise homebuyers. Resolution applicants would have to make mammoth financial commitments to succeed.

Shortcomings in the current regime

While the proposed Amendment is a relief to the real estate developers and the allottees, the specific contours of the process remain primarily undefined, especially in terms of a monitoring mechanism. In Flat Buyers⁵, the Tribunal directed the resolution professional to ensure the completion of the project with the funds provided by the lender and the amount generated from allottees. However, the Tribunal made no reference to the 70% requirement. Similarly, the Supreme Court in Anand Murti v. Soni Infratech (P) Ltd.⁶ and Amit Katyal v. Meera Ahuja⁷ upheld the concept of reverse CIRP but did not mandate this requirement under RERA.

Further, in Whispering Tower Flat Owner Welfare Assn. v. Abhay Narayan Manudhane⁸, the Tribunal allowed project-wise reverse CIRP, but no mention was made of this requirement. However, in Ram Kishor Arora v. Union Bank of India⁹ (hereinafter, “Supertech”), the Tribunal directed the RP to ensure that all receivables are maintained in a separate account. Although the Tribunal’s vigilant stance in Supertech¹⁰ is appreciable, the same can be attributed to the peculiarities of the facts in the case as the Uttar Pradesh RERA had reported prior mismanagement of this separate fund.

Therefore, the court’s approach to establishing a monitoring mechanism for the promoters’ utilisation of funds must be more consistent.

The Meld Model

(i) The ELP analysis

Exclusive legal positivists posit that a legal question can only be settled by referencing legally binding sources. When analysing reverse CIRP as formulated in Flat Buyers¹¹, from the perspective of ELP, it is clear that the NCLAT’s reasoning is not grounded in any source of law. In fact, by making it a promoter-driven process, the Tribunal has supplanted its logic with that of the legislature. The NCLAT created new terms that would conflict with Section 29-A of the Code¹², disqualifying the debtor company’s promoter from becoming a resolution applicant. As mentioned in Chitra Sharma v. Union of India¹³, this section prevents the backdoor entry of promoters who may attempt to regain control of the entity. NCLAT in Flat Buyers¹⁴ introduced the terms “intended lender” and an “outsider financial creditor”, essentially promoters who “intend” to be a lender while staying outside the CIRP process. The assumption here is that the allotters could get their homes faster without third-party involvement on behalf of them. This falls foul of the Code, which advocates for severance with the suspended management once CIRP has been initiated. The NCLAT seems to have loosened this key mandate of the Code.

This does not mean that the process by itself has no merit. Undoubtedly, this judicial experiment has brought much-needed respite to homebuyers. However, going against the letter of the law without sufficiently analysing the implications of this decision violates the ELP principles. One such implication could be siphoning off funds by the promoter if adequate safeguards are not put in place. While Judges in Supertech¹⁵ ordered the transfer of 70% of the funds to a separate RERA account, no such condition was placed in other cases, including Flat Buyers¹⁶. Therefore, while this judicial intervention was a welcome step for the allottees, it still needs to be implemented with sufficient guidance. The critique of the ELP scholars is that in the absence of adherence to the letter of the law, the burden of courts to establish the necessity and legitimacy of the said deviation should be high. This would boost the confidence of the stakeholders in judicial intervention while also ensuring a certain degree of predictability. However, this burden still needs to be fulfilled in the present case, given the uncertainty regarding the checks and balances over the promoter. This could lead to siphoning off funds, which would shake up the legitimacy of the reverse CIRP process itself. Therefore, inconsistency in the implementation militates against the principles of ELP and might also sidestep the policy goals of the Code itself, as seen in the case of Section 29-A.

(ii) Interplay of law and economics: Need for settling the dust

Louis Kaplow has given us two dimensions of legal commands: rules (ex ante) and standards (ex post). Rules differentiate between legal and illegal. On the other hand, standards are general legal criteria requiring the judicial application of mind. Kaplow has argued that the choice between the two has to be made by considering the costs associated with both. Standards may have lower promulgation costs than rules, but their enforcement costs would be much higher. This is because the contours of a standard can only be gradually specified by judicial decisions. This is precisely what is happening with reverse CIRP, imprecise standards are used when creating a separate account as per RERA.

Because there is no ex-ante rule for promoters to follow, there is ample space for ambiguity, which would lead to weak enforcement. If there had been an ex-ante rule, monitoring the promoter’s activities would have become more accessible. The Amendment currently provides that whenever there is a default by a real estate promoter, a project-wise CIRP will have to be carried out. However, this only gives us a standard without actually giving the actors specific rules to abide by. This means that adjudicatory bodies will have to do an ex-post assessment to check for abuse of funds in case of a dispute. An ex-ante rule regarding this can significantly reduce the costs of monitoring. Borrowing from the Meld Model, the situation as it exists right now will create a myriad of transaction costs. Judges would have to determine whether the promoters had siphoned off funds without guiding principles. Two, the promoters will be uncertain about their expected conduct to escape liability.

However, that is not to say that ex-ante policies are without faults; Kaplow argues that they suffer from high economic costs. However, the alternative of having a toothless monitoring mechanism in place may result in more significant externalities and an extraordinarily high cost of failure of the reverse CIRP process. As Kaplow has argued, the final choice depends on the comparative cost-benefit analysis between having an ex-ante and ex-post regime. Therefore, it is proposed that an ex-ante rule mandating a separate account for such projects be put in place.

Concluding remarks

In all fairness, the NCLAT has been highly pragmatic in its experimentation of reverse CIRP. The court has rightly protected the rights of home buyers by giving priority to their needs. Yet, with specific guidelines, this judicial innovation may become more focused on being the saviour of the allottees without defining the contours of the process. On a macro level, the risk is that siphoning off funds may scuttle a vital tenet of the Code as enshrined under Section 29-A, keeping erstwhile promoters at bay. Policymakers, thus, would be well advised to formulate a mandatory RERA account requirement for promoters spearheading the reverse CIRP. The proposed Amendment must explain how this reverse CIRP will be carried out. However, more than mandating a project-wise CIRP, which the Amendment currently does, fails to address the core problem of promoters benefiting at the expense of other stakeholders. There needs to be clarity on how this independence between projects will be ensured, and the workability and legitimacy of reverse CIRP hinge upon remedying this problem.